There seems to be more optimism that a deal can be reached before end year on the back of Obama-Boehner direct talks. But views of what constitutes “success” vary widely, and notably how DC and NY look at the question seems quite a bit different.

In sum:

Market expectations seem centered around outcomes that kick-the-can through 2013 and produce modest deficit reduction; a full cliff dive or a true grand bargain are seen as unlikely and if either were to occur would lead to a substantial repricing of assets.

Proposals that involve short-term fixes and leave major elements of the cliff for debate next year are likely to be perceived less favorably by markets than in DC, and this represents a downside risk perhaps under-appreciated by policymakers.

The debt limit matters a lot to markets, and therefore is rightly part of the policy debate.

State of play on the options

The outline of a potential compromise seems to be taking shape: about $1 trillion (or a bit more) in new revenue through some combination of tax rate increases (e.g., income, estate, cap. gains and dividend) and limits of deductions, a comparable amount of spending cuts including entitlement reforms (and a generous counting of previously agreed measures), deferral of the sequester in the 2013 fiscal year, an AMT patch, and a fix to Medicare payments to providers (“Doc fix”). If coupled with a debt limit extension, this seems as good as can be hoped for before end year. If the payroll tax cut and extended unemployment insurance (UI) benefits are allowed to lapse, this would produce about 1- 1½ percentage points of fiscal drag and a ¾-1 percent direct effect on GDP--meaningful adjustment but far less scary than a full cliff dive. Reaching such a deal by end year may still be a less-than-50/50 proposition, and likely would leave important details to be worked out in 2013. This isn’t a Grand Bargain on the Simpson-Bowles model. But if achieved, it looks to be somewhat better than what is currently priced into markets, suggesting that improved confidence and risk appetite should provide a partial offset to the projected drag.

Should efforts at this deal fail, there is talk (primarily on the Republican side) of an interim arrangement that extends the AMT and middle class tax cuts, but lets the other provisions expire, to be fought over again in the run-up to the debt limit at end February/early March. Chris Krueger at Guggenheim Securities, who has done a great job of following the cliff from the start, calls this his “break glass” scenario. Other proposals offer small “down payments” and general targets to achieve in 2013. How much fiscal drag these approaches cause depends on the ultimate deal. But failure to do better, lack of credibility that policymakers will deliver at the second stage, and continued uncertainty and concern about another debt limit showdown is likely to weigh materially on markets.

Finally, if we go off the cliff and stay there, it would result in additional fiscal drag of around 4 percent of GDP next year, which would almost certainly produce several quarters of negative growth in the US and bring global growth near the 2.5 percent level that we usually think of a signaling a global recession. Further, as the IMF has highlighted in the European context, austerity in the current environment of slow growth and substantial slack can have out-sized effects, tilting the risks to the downside.

Measuring success

What constitutes success in these negotiations? Is it simply that it gets us past December 31st with less disruption than going fully off the cliff? That it deals with the debt limit and thereby resolves uncertainty for 2013? Or is it whether it makes a material step towards a sounder long-term fiscal position, the most important challenge that we face?

My sense is that DC and NY agree on the danger of fully going off the cliff, and share skepticism that a grand bargain can be achieved by end year. Informal surveys of investors suggest a majority expect a stop-gap/kick-the-can measure, with only small percentages expecting either a comprehensive deal by year end or a complete fall off the fiscal cliff. This raises two concerns. First, that markets are underestimating the risk of going off the cliff, either permanently or temporarily with agreement only at the debt limit around the end of February. Second, that for many market participants, the middle ground option of a stop-gap measure involves addressing most elements of the cliff for a period of time (perhaps one year) and dealing with the debt limit. Yet, short of the compromise deal discussed above, many scenarios provide less breathing space and substantial uncertainty in the first quarter of 2013. From this perspective, markets may be pricing more “success” than is reasonable given where we are today.